ch186 - CHAPTER CHECKLIST &lt;When you have completed your...

ECO2013 Fall 03 Cobbe Chapter 18 Page 1 of 9 < When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Discuss whether fiscal policy or monetary policy is the better stabilization tool. 1 Explain the rules-versus-discretion debate and compare Keynesian and monetarist policy rules. 2 Assess whether policy should target the price level rather than real GDP. 3 18.1 FISCAL VERSUS MONETARY POLICY < Policy Effects The Effects of Monetary Policy The two steps in the transmission of monetary policy are: Step 1 A change in the money supply influences the interest rate. Step 2 A change in the interest rate influences investment and other interest-sensitive components of aggregate expenditure. Step 3 A change in the interest rate influences short-term international capital flows and thus the exchange rate of the dollar, and therefore exports and imports. 18.1 FISCAL VERSUS MONETARY POLICY Step 1 Whether a given increase in the money supply decreases the interest rate by a lot or a little depends on the sensitivity of the demand for money to the interest rate . Step 2 Whether a given decrease in the interest rate increases aggregate expenditure by a lot or a little depends on the sensitivity of investment and other components of aggregate expenditure to the interest rate. Step 3 Whether a given decrease in the interest rate reduces the exchange rate by a lot or a little depends on the sensitivity of the exchange rate to the interest rate; and whether this increases net exports by a little or a lot depends on the sensitivity of exports and imports to changes in the exchange rate. These ‘sensitivities’ are empirical questions that are hotly disputed. 18.1 FISCAL VERSUS MONETARY POLICY In this figure, when the money supply increases from $1 trillion to $1.2 trillion, the interest rate falls from 6 percent to 4 percent a year and investment increases from $2 trillion to $4 trillion. 18.1 FISCAL VERSUS MONETARY POLICY Here, the same change in the money supply lowers the interest rate from 6 percent to 5 percent a year and increases investment from $2 trillion to $2.25 trillion. Monetary policy is less powerful here than in the previous case.

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ECO2013 Fall 03 Cobbe Chapter 18 Page 2 of 9 18.1 FISCAL VERSUS MONETARY POLICY The Predictability of Monetary Policy The steps in the transmission of monetary policy determine the predictability of monetary policy. • At step 1, for a given change in the money supply to have a predictable effect on the interest rate, the demand for money must be predictable. • At step 2, for a given change in the interest rate to have a predictable effect on investment and aggregate expenditure, the investment demand must be predictable. • At step 3, for a given change in the interest rate to have a

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